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Sun 22 Apr 2018 12:04 PM

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Where the Saudi Aramco valuation really sits

Bloomberg's Liam Dinning picks through the numbers to arrive at a realistic valuation of the company ahead of its planned IPO

Where the Saudi Aramco valuation really sits

Last week, Bloomberg managed to unearth some financial data on the oil behemoth as speculation around its IPO continued to circulate. What did it tell us?

Firstly, Saudi Arabian Oil Co, or Aramco, is fantastically profitable, with net income of about $34bn in the first half of 2017, according to figures reviewed – which is more than four times what Exxon Mobil Corp earned in the same period.

Meanwhile, the implied costs of production, including overheads and depreciation, appear to be less than $10 a barrel. Given that Brent crude oil averaged only about $53 a barrel in that period and Aramco was only pumping about 9.9 million barrels of crude oil a day, the implication is this year’s profits will be positively huge.

For prospective investors in the potential initial public offering, though, what matters is how much of that translates into free cash flow and what kind of risk premium gets put on it.

A month ago, I did a very rough calculation of what Aramco might be worth, using a smorgasbord of assumptions. At $80 a barrel, 11 million barrels of crude oil a day, $40bn of annual capital expenditure, and a seven percent free cash flow yield, I got a valuation of just under $1.5trn. That’s a lot of money, albeit a bit below the $2trn Saudi officials appear to want.

The new data doesn’t help on that front. Adjusting my assumptions based on these figures yields a new valuation of about $1.2trn.

Where did that value go?

One big difference is how much of a royalty the Saudi Arabian government takes off the top of each barrel of oil produced. In my earlier calculation, I assumed a flat 20 percent of revenue. Instead, there is a sliding scale based on oil prices: 20 percent up to $70 a barrel, 40 percent on each dollar above that to $100, and then a marginal 50 percent on the each above that.

I’ve assumed, as before, that natural gas and ethane production remain flat and at fixed prices, as well as natural gas liquids output being 1.4 million barrels a day at 50 percent of the crude oil price.

The figures I’ve seen still lack a certain amount of detail, especially in terms of the real split of upstream and downstream profits. The figures for the first half of 2017 also include a peculiar payment of around $21bn, on a cash basis, from the government to Aramco. This could be one-off but I am assuming it largely relates to reimbursing the company for subsidies on domestic fuel sales.

Using the adjusted assumptions, there are a range of theoretical market caps for Aramco at different oil prices and free cash flow yields, which are represented in the graph above. It’s important to remember that these outputs remain preliminary estimates that are still dependent on a lot of assumptions. The prospectus remains an elusive but must-see document. That said, the implied valuations still point to a few broad conclusions.

The journey to $1.5trn

First, indications that Saudi Arabia reportedly would like to see oil at $80 make sense in the context of the planned IPO. Second, royalties and taxation are critical levers for the government to adjust heading into the IPO if it wants to boost the valuation.

Higher government take at higher oil prices is pretty standard procedure in this operating environment. But in removing some of the potential upside, it also removes some of the incentive to buy (as evidenced in other national oil company valuations).

Which leads into the third point, namely that the valuation remains very sensitive to the risk premium. A yield of about seven percent looks like the bare minimum to me, given where other oil majors trade and Saudi Arabia’s peculiar risks. A more benign taxation regime might help on that front, albeit at the cost of revenue flowing directly to the government.

Overall, though, a $2trn figure still looks very unlikely, absent triple-digit oil prices. And as last week’s geopolitical gyrations have shown, higher oil prices would likely go hand-in-hand with a higher risk premium on Aramco’s home.

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